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Civil Systems Planning Benefit/Cost Analysis

Civil Systems Planning Benefit/Cost Analysis. Scott Matthews 12-706 / 19-702. Announcements. HW 2 returned Install Decision Tools Suite ASAP (in case there are problems) Installation in CEE cluster done (Group) Project 1 due Friday Revision posted - Questions? HW 3 Out.

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Civil Systems Planning Benefit/Cost Analysis

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  1. Civil Systems PlanningBenefit/Cost Analysis Scott Matthews 12-706 / 19-702

  2. Announcements • HW 2 returned • Install Decision Tools Suite ASAP (in case there are problems) • Installation in CEE cluster done • (Group) Project 1 due Friday • Revision posted - Questions? • HW 3 Out 12-706 and 73-359

  3. Three Legs to Stand On • Pareto Efficiency • Make some better / make none worse • Kaldor-Hicks • Program adopted (NB > 0) if winners COULD compensate losers, still be better • Fundamental Principle of CBA • Amongst choices, select option with highest ‘net’ benefit 12-706 and 73-359

  4. Welfare EconomicsConcepts • Perfect Competition • Homogeneous goods. • No agent affects prices. • Perfect information. • No transaction costs /entry issues • No transportation costs. • No externalities: • Private benefits = social benefits. • Private costs = social costs. 12-706 and 73-359

  5. Profit Maximization under Perfect Competition P P S = MC S D p p = MR D q Q Q 12-706 and 73-359

  6. Price A B P* 0 1 2 3 4 Q* Quantity Benefits with WTP • Total/Gross/User Benefits = area under curve or willingness to pay for all people = Social WTP = their benefit from consuming = sum of all WTP values • Receive benefits from consuming this much regardless of how much they pay to get it 12-706 and 73-359

  7. Price A B P* 0 1 2 3 4 Q* Quantity Net Benefits A B • Amount ‘paid’ by society at Q* is P*, so total payment is B to receive (A+B) total benefit • Net benefits = (A+B) - B = A = consumer surplus (benefit received - price paid) 12-706 and 73-359

  8. Market Supply Curves • Producer surplus is similar to CS -- the amount over and • Above cost required to produce a given output level • Changes in PS found the same way as before Supply=MC Price P* PS* P1 PS1 TVC* TVC1 Quantity Q1 Q* Producer Surplus = Economic Profit 12-706 and 73-359

  9. Social Surplus Social Surplus = consumer surplus + producer surplus Is difference between areas under D and S from 0 to Q* Losses in Social Surplus are Dead-Weight Losses! P S P* D Q* Q 12-706 and 73-359

  10. Allocative Efficiency Allocative efficiency occurs when MC = MB (or S = D) Equilibrium is max social surplus - prove by considering Q1,Q2 S = MC Price b P* D = MB a Q1 Q* Q2 Quantity Is the market equilibrium Pareto efficient? Yes - if increase CS, decrease PS and vice versa. 12-706 and 73-359

  11. Further Analysis Price Old NB: CS2 New NB: CS1 Change:P2ABP* A CS1 P2 B C P* 0 1 2 Q2 Q* Quantity • Assume price increase is because of tax • Tax is P2-P* per unit, tax revenue =(P2-P*)Q2 • Tax revenue is transfer from consumers to gov’t • To society overall , no effect • Pay taxes to gov’t, get same amount back • But we only get yellow part.. 12-706 and 73-359

  12. Deadweight Loss Price A CS1 P2 B P* 0 1 2 Q* Q1 Quantity • Yellow paid to gov’t as tax • Green is pure cost (no offsetting benefit) • Called deadweight loss • Consumers buy less than they would w/o tax (exceeds some people’s WTP!) - loss of CS • There will always be DWL when tax imposed 12-706 and 73-359

  13. Net Social Benefit Accounting • Change in CS: P2ABP* (loss) • Government Spending: P2ACP* (gain) • Gain because society gets it back • Net Benefit: Triangle ABC (loss) • Because we don’t get all of CS loss back • OR.. NSB= (-P2ABP*)+ P2ACP* = -ABC 12-706 and 73-359

  14. Types of Costs • Private - paid by consumers • Social - paid by all of society • Opportunity - cost of foregone options • Fixed - do not vary with usage • Variable - vary directly with usage • External - imposed by users on non-users • e.g. traffic, pollution, health risks • Private decisions usually ignore external 12-706 and 73-359

  15. Pollution (Air or Water) Typically supply (MC) only private, not social costs. Social costs higher for each quantity P S#:marginal Social costs S*: marginal Private costs P# P* What do these curves, Equilibrium points tell us? D Q Q# Q* 12-706 and 73-359

  16. What is WTP by society to avoid? Typically supply (MC) only private, not social costs. Social costs higher for each quantity P S#:marginal Social costs S*: marginal Private costs P# P* D Q Q# Q* 12-706 and 73-359

  17. What is WTP by society to avoid? Differences in cost functions represent the alternative ‘valuations’ of the product - Thus difference between them WTP to avoid costs P S#:marginal Social costs S*: marginal Private costs P# P* D Q Q# Q* 12-706 and 73-359

  18. Pollution (Air or Water) Relatively too much gets produced, At too low of a cost - how to Reduce externality effects? P S#:marginal Social costs S*: marginal Private costs DWL P# P* D Q Q# Q* 12-706 and 73-359

  19. Pollution (Air or Water) Government can charge a tax ‘t’ on Each unit, where t = distance between What are CS, PS, NSB? P S#:marginal Social costs S*: marginal Private costs P# t P* D Q Q# Q* 12-706 and 73-359

  20. Pollution (Air or Water) CS = (loss) A+B PS=(loss) E+F P S#:marginal Social costs S*: marginal Private costs P# t A B P* F E P# - t D Q Q# Q* 12-706 and 73-359

  21. Pollution (Air or Water) Third parties: (gain) B+C+F (avoided quantity between S curves) Govt revenue: A+E Total: gain of C P S#:marginal Social costs S*: marginal Private costs P# t C A B C is reduced DWL of pollution eliminated by tax** P* F E P# - t D Q Q# Q* **This cannot be a perfect reduction in practice - need to consider administrative costs of program 12-706 and 73-359

  22. Distorted Market - Vouchers • Example: rodent control vouchers • Give residents vouchers worth $v of cost • Producers subtract $v - and gov’t pays them • Likely have spillover effects • Neighbors receive benefits since less rodents nearby means less for them too • Thus ‘social demand’ for rodent control is higher than ‘market demand’ 12-706 and 73-359

  23. Distortion : p0,q0 too low What is NSB? What are CS, PS? S Social WTP P S-v P0 P1 DS: represents higher WTP for rodent control DM Q Q0 Q1 12-706 and 73-359

  24. Social Surplus - locals Make decisions based on S-v, Dm What about others in society, e.g. neighbors? P P S S-v P1+v C A P0 B E P1 DS Because of vouchers, Residents buy Q1 DM Q Q0 Q1 12-706 and 73-359

  25. Nearby Residents Added benefits are area between demand above consumption increase What is cost voucher program? P P S S-v F P1+v C A G P0 B E P1 DS DM Q Q0 Q1 12-706 and 73-359

  26. Voucher Market Benefits • Program cost (vouchers):A+B+C+G+E ---- • Gain (CS) from target pop: B+E • Gain (CS) in nearby: C+G+F • Producers (PS): A+C • --------- • Net: C+F 12-706 and 73-359

  27. Notes about Public Spending • Resource allocation to one project always comes at a ‘cost’ to other projects • E.g. Pittsburgh stadium projects • “Use it or Lose it” • There is never enough money to go around • Thus opportunity costs exist • Ideally represented by areas under supply curves • Do not consider ‘sunk costs’ • Three cases (we will do 2, see book for all 3) 12-706 and 73-359

  28. Example: Change in Demand for Concrete Dam Project • If Q high enough, could effect market • Shifts demand -> price higher for all buyers • Moves from (P0,Q0) to (P1,Q1).. Then?? Price D+q’ D S P1 P0 a Q1 Q0 Quantity 12-706 and 73-359

  29. Another Example: Change in Demand • Original buyers: look at D, buy Q2 • Total purchases still increase by q’ • What is net cost/benefit to society? Price D+q’ D S P1 P0 a Q1 Q2 Q0 Quantity 12-706 and 73-359

  30. Another Example: Change in Demand • Project spends B+C+E+F+G on q’ units • Project causes change in social surplus! • Rule: consider expenditure and social surplus change Price D D+q’ S P1 C A F B P0 G E G G Q1 Q2 Q0 Quantity 12-706 and 73-359

  31. Dam Example: Change in Demand • Decrease in CS: A+B (negative) • Increase in PS: A+B+C (positive) • Net social benefit of project is B+G+E+F Price D D+q’ S P1 C A F B P0 G E G G Q1 Q2 Q0 Quantity 12-706 and 73-359

  32. Final Thoughts: Change in Demand • When prices change, budgetary outlay does not equal the total social cost • Unless rise in prices high, C negligible • So project outlays ~ social cost usually • Opp. Cost equals direct expenditures adjusted by social surplus changes Quantity 12-706 and 73-359

  33. Secondary Markets • When secondary markets affected • Can and should ignore impacts as long as primary effects measured and undistorted secondary market prices unchanged • Measuring both usually leads to double counting (since primary markets tend to show all effects) • Don’t forget that benefit changes are a function of price changes 12-706 and 73-359

  34. Monopoly - the real game • One producer of good w/o substitute • Not example of perfect comp! • Deviation that results in DWL • There tend to be barriers to entry • Monopolist is a price setter not taker • Monopolist is only firm in market • Thus it can set prices based on output 12-706 and 73-359

  35. Monopoly - the real game (2) • Could have shown that in perf. comp. Profit maximized where p=MR=MC (why?) • Same is true for a monopolist -> she can make the most money where additional revenue = added cost • But unlike perf comp, p not equal to MR 12-706 and 73-359

  36. Monopoly Analysis In perfect competition, Equilibrium was at (Pc,Qc) - where S=D. But a monopolist has a Function of MR that Does not equal Demand So where does he supply? MC Pc Qc MR D 12-706 and 73-359

  37. Monopoly Analysis (cont.) Monopolist supplies where MR=MC for quantity to max. profits (at Qm) But at Qm, consumers are willing to pay Pm! What is social surplus, Is it maximized? MC Pm Pc Qm Qc D MR 12-706 and 73-359

  38. Monopoly Analysis (cont.) What is social surplus? Orange = CS Yellow = PS (bigger!) Grey = DWL (from not Producing at Pc,Qc) thus Soc. Surplus is not maximized Breaking monopoly Would transfer DWL to Social Surplus MC Pm Pc Qm Qc D MR 12-706 and 73-359

  39. Natural Monopoly • Fixed costs very large relative to variable costs • Ex: public utilities (gas, power, water) • Average costs high at low output • AC usually higher than MC • One firm can provide good or service cheaper than 2+ firms • In this case, government allows monopoly but usually regulates it 12-706 and 73-359

  40. Natural Monopoly Faced with these curves Normal monop would Produce at Qm and Charge Pm. We would have same Social surplus. But natural monopolies Are regulated. What are options? a Pm d P* AC b e MC c Qm Q* D MR 12-706 and 73-359

  41. Natural Monopoly Forcing the price P* Means that the social surplus is increased. DWL decreases from abc to dec Society gains adeb a Pm d P* AC b e MC c D Qm Q* Q0 MR 12-706 and 73-359

  42. Monopoly • Other options - set P = MC • But then the firm loses money • Subsidies needed to keep in business • Give away good for free (e.g. road) • Free rider problems • Also new deadweight loss from cost exceeding WTP 12-706 and 73-359

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